The threat of trade war sparked a stampede to safe assets this week, sending the 10-year US Treasury bond yield to a near record low. But what’s happening to bonds reflects something bigger than the latest news. Rates are low in other countries too—extremely low. In Europe the entire German bond curve is in negative territory and more than $13 trillion worth of bonds are offering negative rates—that is, bond holders pay to own the security. Nor is this a new development: Bond yields in developed markets have been trending down for the last 20 years.
Years ago such low rates were unthinkable. Who would pay to lend someone money? In the late 1990s the US government ran a surplus and rates were nearly 6%, now the deficit is expected to top $1 trillion and the 10-year yield is 1.5%. Fortunes have been lost betting rates will go back up, and yet they keep going down. Will it last and how did we get here?
Interest rates are market prices, which means they are a function of the supply and demand of bonds. There is plenty of supply—the US is running a many-trillion dollar debt and needs to sell bonds to pay for it—but not enough to satisfy all the demand for its debt at higher interest rates. The demand is driven by an insatiable desire for low-risk assets. Bonds are generally seen as a less risky asset than stocks. Unlike most other assets, they offer certain payments for a fixed amount of time. Even if the company or country that issued the bond goes bust, bond holders are often still paid something. Of course, some countries and companies are risker than others. The riskier a bond is, the more it normally pays, since investors are compensated for taking risk.
And bonds have never been less risky. Traditionally, even bonds from countries with a low chance of default contained some amount of risk because there was a risk of inflation or that bond prices would change. Since rates and inflation have been low and steady, neither of these factors are seen as likely, which means investors will buy bonds with lower yields. A low-risk asset is especially attractive when markets feel uncertain, like now when investors fear either a recession or a trade war that will crash the stock market. Even negative rates that are locked in can be more compelling than the alternative.
Further, certain institutions, like pension funds or banks, often are required by statute or their charter to buy bonds, no matter the rate. For example German pension funds can only invest 35% of their assets in risky securities, and have traditionally held mostly bonds. Regulation also encourages banks to hold bonds on their balance sheet because it is considered a safe asset.
A closer look at who makes up this demand can tell us where bonds are headed and how we got here.
In the US the biggest buyer of US government bonds is the US government. For example, when Social Security takes in more in taxes than it pays in benefits, all that excess revenue is invested in special US bonds not available to the public but sold based on market prices. Nearly all government bond buyers are agencies associated with retirement: Social Security, the Medicare trust fund, military pensions, and federal retirement programs, represent almost 90% of bonds bought by the US government. In 2018, almost 26% of the America’s $21 trillion debt was intra-government lending. Some pundits argue the government lending money to itself does not count as debt, but is merely an accounting maneuver. Technically that may be correct, but these bonds do represent real debt, the payments promised to future retirees in exchange for taxes or pension contributions today. The Social Security and Medicare trust fund assets don’t even cover what’s been promised to future retirees, so in fact the debt owed to Social Security and Medicare understates what the government truly owes to retirees. In all, obligations to American retirees makes up that largest share of government loans.
The figure below summarizes who buys what, by showing the percentage of debt each type of buyer owns:
Individual savers (who own mutual funds and saving bonds) and the Fed (who expanded their balance sheets during the financial crisis) remain a fairly small buyers of bonds. The biggest buyers are the government’s retirement obligations and foreign buyers which includes foreign governments and corporations. One reason bonds yields have been trending down is almost all bond buyers have been buying more over the years, especially foreign investors. The figure below plots bond holdings over the last 25 years by type of buyer.
Whether you benefit from low rates depends if you are a saver or borrower. Low rates tend to be bad for retirees who usually own more bonds and face higher annuity prices. Financing retirement spending while avoiding risk has become incredibly expensive. Baby boomers may have benefited from years of economic growth and a rising stock market, but low rates makes their retirement much more expensive. Meanwhile borrowers, holders of student debt, and mortgages face lower borrowing costs. Regardless if they are retiring or just starting out, all savers will get a lower return on their investments, or be compelled to take on more risk to produce a higher return. How households will respond to more risk is uncertain, and if stock prices fall it could mean more economic instability. Alternatively, a lower cost of capital can increase investment and spur more growth, which benefits everyone.
Historically, financial economists assumed bond yields revert to the mean, or, in other words, that they hover around a long-term average and what goes down (or up) must eventually return to normal. But there are reasons to think rates may be lower for the foreseeable future. In a more global world there will be more demand among foreign buyers of US debt, buying debt stabilizes (or lowers) their currency and buying foreign bonds can hedge risk. Bond yields will also be lower because an aging population means more savers and bond buyers. If low, stable inflation persists, rates will also be lower than their historical averages when rates had to compensate investors for higher inflation.
But things could change. Asian investors are looking closer to home for investment. If there’s less trade with western countries, they’ll have less need to buy our debt. The US government will also be buying less debt in the future—starting next year Social Security benefits will exceed tax revenue, meaning the government will not buy so much of its own debt as the trust fund is expected to start shrink to zero by 2035. This all mean the two biggest buyers of US debt will probably be buying less in the future. Meanwhile, if the government does not reform entitlements or starts offering new ones like Medicare For All, it will be issuing even more debt in the future. More supply and less demand could mean rates just might rise again.